Question

What are the three tools of financial analysis? Explain what they are and how to use them.

Answer 1

There are many tools for Financial Analysis among them three important tools of financial analysis are (a) Comparative Financial Statements, (b) Common Size Statements, and (c) Ratio Analysis and Trend Analysis.

1. Preparation of Comparative Financial Statements:

Comparative Financial Statements refer to the statements of financial position of a business, which are prepared in such a way as to provide a time perspective to the various elements embodied in the financial statements.

These statements include two types of analytical statements. They are Comparative Balance Sheets and Comparative Income Statement. In these statements figures are placed side by side for two or more periods in order to facilitate comparison.

They also facilitate comparison among two or more firms that belong to the same industry. Comparison may be regarding to profitability and financial soundness.

Example: Comparitive Financial statement (Horizontal Analysis)

	FY 2012-13	FY 2011-12	Change	Change%
Revenue	1224	1140	84	7.4
Cost of Goods Sold	554	519	35	6.7
Gross Profit	670	621	49	7.9
General,Selling and Administrative Expenses	436	392	44	11.2
Operating Profit	234	239	5	2.2
Interest Expense	16	14	2	14.3
Profit Before Tax	218	215	3	1.4
Provision for Tax	66	72	-6	-8.3
Profit After Tax	152	143	9	6.3

2. Common-size Financial Statement Analysis (Vertical Analysis): Vertical analysis is applicable for internal performance review as well as for comparison to peers and bench-marking. In vertical analysis all the items in a particular statement are represented as a percentage of a particular item. For example, Operating Expenses, Depreciation, Amortization, Profit before tax, Tax, Profit after tax, etc. may be represented as a percentage of Sales in the Income Statement. Common standard base can easily reveal the internal make-up of financial statements and any proportionate increase and decrease of the same.

Vertical analysis is also put to use for comparison across companies as financial statements are converted to common-size format, which can then be used to compare with competitor or industry averages, highlighting key differences which can then be analyzed.

Below is an example of a Common Size Income Statement. Values are expressed as %age of Revenue.

Common Size Income Statement for the year FY 2012-13 (%) FY 2011-12(%) Revenue 100 100 Cost of Goods Sold 45.2 45.6 Gross Profit 54.8 54.4 General,Selling and Administrative Expenses 35.6 34.4 Operating Profit 19.2 20 Interest Expense 1.1 1.2 Profit Before Tax 18.1 18.8 Provision for Tax 4.7 5.6 Profit After Tax 13.4 13.2

3. Ratio Analysis: Ratio analysis is the most widely used tool of financial statement analysis. A ratio gives relationship between two numbers, in this case items in the financial statements. Ratios are popular because they readily allow internal evaluation as well as comparison across firms. The ratios are categorized according to activities or functions they perform or the information they provide. For example, profitability ratios measure the profit making capability of the company.

4. Trend Analysis: Trend analysis is used to reveal the trend of items with the passage of time and is generally used as a statistical tool. Trend analysis is used in conjunction with ratio analysis, horizontal and vertical analysis to spot a particular trend, explore the causes of the same and if required prepare future projections.

Example

Particulars	Base year	Y 1	Y 2	Y 3	Base year %	Y 1%	Y 2%	Y3%
Cash	20	25	20	30	100	125	100	150
Debtors	40	50	60	80	100	125	150	200
Stock	60	80	70	100	100	133.33	119.67	166.67
Total Current Assets	120	155	150	210	100	129.17	125	177.70